In the May 1977 issue of Fortune, Buffett published an article entitled “How Inflation Swindles the Equity Investor.” The true focus of the article is on how a corporation operates internally and how those internal processes interact with external factors in the economy and financial markets. The article focuses on how external forces—such as inflation—affect corporate behavior and how decisions made by corporations in response to these forces may harm equity investors.
Internal Compounding Drives Stock Prices
In the 1977 paper, Buffett claimed that the main issue with the stock market was that the return on capital had not increased with inflation and appeared to be stuck at 12 percent. When Buffett wrote his article, inflation and interest rates had climbed dramatically to 10% and were headed for 15% five years later. Contrary to popular expectation, corporate earnings did not rise to offset inflation.
Buffet described stocks as “equity coupons,” which, unlike regular bond coupons, do not have a set value but instead have the potential to grow thanks to the internal compounding of 12%. Stocks were a fantastic deal when they traded close to book value, as they did at the start of the great 1950s bull market. Bond coupons could not be reinvested directly at par value and still cannot be done. However, you can with stocks as firms with either no or little dividends does it for you without any tax repercussions, making the growth stocks of the 1950s an incredible bargain.
Higher Inflation Does Not Translate Into Higher Returns on Capital
Currently, the S&P 500’s return on invested capital is around 10% (10.1% in Q1 2022). With the CPI, the official measure of inflation, currently at 8.6%, businesses have hardly made any money overall over the past year.
The S&P 500 is also trading at 3.8 times book value, which means that the true rewards for investors are incredibly negative.
Why then does higher inflation not translate into higher returns on capital?
Buffett explored five ways investors hoped return on book value could be improved. The two most intriguing of strategies were increasing leverage and getting leverage at a lower cost. Given growing inflation and interest rates, the latter seems quite impossible. In actuality, almost all debt rollovers came with higher interest rates. Meanwhile companies were seeking to increase leverage to expand in an inflationary environment. That increase in debt quickly became burdensome as debt was rolled over at inevitably higher rates.
“To raise that return on equity, corporations would need at least one of the following: (1) an increase in turnover, i.e., in the ratio between sales and total assets employed in the business; (2) cheaper leverage; (3) more leverage; (4) lower income taxes, (5) wider operating margins on sales.”
Many of these points, if not all of them, are probably moving in the opposite direction. In the event of a triple whammy of recession, increasing interest rates, and CPI. The equities market would have a long way to fall without central bank intervention. CPI may potentially surpass the market’s return on capital.
Buffett did not hold the modern perspective that debt and equity were interchangeable and could be adjusted at will to obtain whatever debt to equity ratio served a company’s purpose. Rather than ROIC, his preferred metric of profitability has always been ROE (return on equity capital) (return on total invested capital). He has occasionally shown a willingness to purchase debt when the rate of return was high enough to make it worthwhile to take the risk, but he has refrained from issuing a sizable amount of debt to meet Berkshire’s capital requirements. He has only ever issued debt under extremely favorable circumstances, effectively giving it away for free (as the debt in yen he used to buy the $6.5 billion of Japanese trading companies).
Buffet’s Take On Inflation
Buffet compared inflation to a tapeworm.
For inflation acts as a gigantic corporate tapeworm. That tapeworm preemptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism.
Whatever profits you make currently, the replacement costs of your property, plant and equipment will always increase. That is why business with low returns will suffer as the “tapeworm” will devour everything with no leftovers.
Industry-wide moves to “just-in-case” from “just-in-time” inventory management only adds to the working capital drag. Another hidden impact comes as maintaining the current asset base becomes more expensive when the replacement cost of maintenance capex rises with inflation.
Stock Equities As An Inflation Hedge
It is often said that equities act as a hedge against inflation. Companies that has pricing power can increase prices to match the inflation rates. However, lifting price without adding any value risks an offsetting decline in volume as customers pockets are not a bottomless pit. Recurring, non-discretionary revenue is key.
Increased inflation creates false growth. Some revenue growth is certain due to LIFO, and earnings increase is possible (if inflation picks up speed). This is because sales are growing faster than fixed assets. However, the advantages are likely to be small and insufficient to significantly boost returns on equity investments.
Topline revenues are growing more quickly than expected, but nominal earnings increase in tandem with inflation. Therefore, stocks are not an inflation hedge. In fact, the focus should be on free cash flow, whether they will keep up with inflation. Only real cashflow growth per share that creates value for shareholders.
In the long run, quality business is probably the only defense against inflationary pressures.
Investing In An Inflationary Environment
In this situation, buying compounders at prices higher than their book value feels like swimming against the tide.
Later in his career, Buffett made the famous statement that he would rather purchase “a wonderful company at a fair price than a fair company at a wonderful price” Even though they can appear overvalued, he keeps onto his businesses for a very long time—ideally “forever.” He avoids making significant acquisitions of businesses at huge multiples.
And take note that his recent Berkshire action has not been investing heavily in Google or Amazon when their prices dropped, but rather Chevron and Occidental Petroleum.
Buying a company that makes ~20% return on capital that can reinvest all the earnings at that rate for decades is how the great fortunes were made: “… if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you’ll end up with one hell of a result.” (Charlie Munger).
If a company can reinvest all of its cash at a 20% rate of return and has a 20% return on capital, its book value will increase 38 times in 20 years.
However, this outcome can be ruined by both inflation and paying at a higher valuation. In 20 years, the book value would be lower than you paid in real terms if you had paid 8 times the business’s book value and if inflation was 8.6%.
So investing in long-term compounders at close to book value is the best stock to buy. For example, if a company produces a 10% return on capital and you buy it for half of book value, you are getting a 20% return: you’re sailing above inflation rather than being under water.
Overall, I think it is a very well written piece that provides insight into what we may expect in the current economic landscape. I really hope that he can provide an update on this piece and using the data to provide another forecast of the expected inflation and return of capital rates.